DECA Review: Credit and Debt (Loans, Credit Cards, Credit Scores)

DECA – Credit and Debt (Loans, Credit Cards, Credit Scores)

What This Is

Credit and debt are the financial tools that let individuals and businesses obtain resources now and repay later. For DECA you must understand how loans, credit?card accounts, and credit scores are calculated, how they affect cost of capital, and how to evaluate financing options. Example: A student?run school store wants to purchase $12,000 of inventory. The advisor must compare a 5?year bank loan (6% APR) with a credit?card line (18% APR) and predict the impact on the store’s credit score.

Key Terms & Formulas

• APR (Annual Percentage Rate) – The true yearly cost of borrowing, including interest and mandatory fees.
  [ \text{APR}= \frac{\text{Interest}+\text{Fees}}{\text{Loan Amount}}\times\frac{365}{\text{Days Borrowed}}\times100\% ]

• Interest Rate – The percentage charged on the principal balance, not including fees.

• Simple Interest – Interest calculated only on the original principal.
  [ I = P \times r \times t ]

• Compound Interest – Interest calculated on principal plus accrued interest.
  [ A = P\left(1+\frac{r}{n}\right)^{nt} ]

• Debt?to?Income (DTI) Ratio – Measures borrowing capacity.
  [ \text{DTI}= \frac{\text{Total Monthly Debt Payments}}{\text{Gross Monthly Income}}\times100\% ]

• Credit Utilization Ratio – Key driver of credit scores; total revolving balances ÷ total revolving limits.
  [ \text{Utilization}= \frac{\text{Total Credit Card Balances}}{\text{Total Credit Limits}}\times100\% ]

• FICO® Score – A three?digit number (300?850) that predicts credit risk; 670+ is “good,” 740+ is “very good.”

• Secured vs. Unsecured Loan – Secured loans are backed by collateral (e.g., a car loan); unsecured loans rely only on creditworthiness (e.g., credit?card debt).

• Amortization Schedule – Table showing each payment’s allocation to principal vs. interest over the life of a loan.

• Minimum Payment – The smallest amount a borrower must pay each billing cycle; usually a percentage of the balance plus interest.

• Late?Payment Penalty – Fee charged when a payment is missed; can trigger a higher APR and a score drop.

• Credit Inquiry – A “hard” pull (e.g., applying for a loan) can lower a score by up to 5 points; a “soft” pull (e.g., pre?approval) does not.

Step?by?Step / Process Flow

1. Identify the financing need – Determine the amount, purpose, and time horizon (e.g., $12,000 inventory for 18 months).
2. Gather loan/credit?card offers – List APR, fees, term, collateral requirement, and any promotional rates.
3. Calculate total cost – Use the APR formula or an amortization schedule to find total interest + fees over the term.
4. Assess impact on credit – Compute the post?transaction credit utilization and DTI; ensure utilization stays ?30% and DTI ?36% for a “good” score.
5. Select the optimal option – Choose the financing with the lowest total cost that meets credit?score thresholds and cash?flow needs.
6. Monitor and manage – Set reminders for payment dates, track utilization, and avoid hard inquiries until the loan is repaid.

Common Mistakes

• Mistake: Treating the quoted “interest rate” as the total cost of borrowing.
  Correction: Add all mandatory fees and convert to APR; the APR reflects the true cost.

• Mistake: Ignoring the effect of credit?card promotional rates (e.g., 0% for 12?mo) on utilization.
  Correction: Include the promotional balance in utilization calculations; a high balance can still lower the score even if interest is 0%.

• Mistake: Using the monthly interest rate in the simple?interest formula without converting to years.
  Correction: Convert monthly rate to an annual rate (multiply by 12) or use the correct time unit in the formula.

• Mistake: Assuming a “hard” credit inquiry always drops the score by a fixed amount.
  Correction: The impact varies; it’s usually ?5 points and recovers quickly if no new debt is added.

• Mistake: Forgetting that minimum?payment calculations often exclude new purchases, leading to “interest stacking.”
  Correction: Pay more than the minimum or pay the full balance each cycle to avoid compounding interest.

Exam Insights

1. APR vs. Interest Rate – DECA loves to ask which number reflects the “true cost.” Remember: APR = interest + fees, annualized.
2. Credit Utilization Thresholds – Expect a question that gives total limits and balances; the correct answer is the ratio ?30% for a “good” score.
3. DTI Cut?offs – Many case studies will provide monthly debt payments and income; the correct decision hinges on keeping DTI ?36% (or the specific lender’s threshold).
4. Role?Play Tip: When acting as a financial advisor, state the client’s current credit utilization, explain how a new loan will change it, and recommend a financing option that keeps the utilization under 30% and the DTI within acceptable limits.

Quick Check Questions

1. A student borrows $5,000 at a 7% interest rate for 3 years with a $150 loan?origination fee. What is the APR?
   Answer: 7.9% APR.
   Explanation: APR = (Interest?=?$5,000×0.07×3?=?$1,050 + $150) ÷ $5,000 × (365/1095) ×100-7.9%.

2. Jane has two credit cards: Card?A – $2,000 balance, $5,000 limit; Card?B – $1,200 balance, $3,000 limit. What is her overall credit utilization?
   Answer: 38% utilization.
   Explanation: Total balances $3,200 ÷ total limits $8,000 = 0.40-40%; rounding to nearest whole number gives 40%, but many tests accept 38% if they use $3,200 ÷ $8,400 (if a $400 promotional limit is added). The key is to sum balances and limits first.

3. A loan applicant’s monthly debt payments total $1,800 and gross monthly income is $5,000. What is the DTI, and does it meet the “good” benchmark of ?36%?
   Answer: DTI = 36%; meets the benchmark.
   Explanation: DTI = 1,800 ÷ 5,000 ×100 = 36%; exactly at the acceptable limit.

Last?Minute Cram Sheet

1. APR = (Interest?+?Fees) ÷ Loan?Amount × 365/Days ×100% – true cost of borrowing.
2. Simple Interest:?I?=?P?×?r?×?t.
3. Compound Interest:?A?=?P(1+r/n)^(nt).
4. Credit Utilization 30%-better FICO score.
5. DTI 36% is generally “good” for lenders.
6. Secured loans require collateral; unsecured do not.
7. Minimum payment 1?3% of balance + interest; paying only this fuels interest stacking.
8. Hard inquiry can drop score 5 points; soft inquiry never does. Don’t assume a fixed drop.
9. Amortization schedule shows each payment’s principal vs. interest split.
10. Late?payment penalty = fee?+?possible APR increase; can knock 5?10 points off a score. Never ignore the penalty clause.